Category Archives: Theory

When trade raises welfare and lowers measured GDP

This nifty note by Bajona, Gibson, Kehoe, and Ruhl points out that there may be little connection between real GDP and welfare; in fact, welfare-improving trade liberalization may lower measured real GDP. Here’s a simple example in the Heckscher-Ohlin setting:

The intuition behind the decrease in measured real GDP for the autarky to free trade scenario is simple: given factor endowments, the base-year production pattern in country i is the optimal production pattern for country i at the base year prices among all feasible production plans… Any deviation from that production pattern will lower the value of production at those prices.

Freely traded outside goods have non-trivial consequences

Recall that assuming a freely traded, CRS-produced outside good when writing a trade model is non-trivial [Davis (AER, 1998)]:

In the present paper, I show that what previously was regarded as an assumption of convenience – transport costs only for the differentiated goods – matters a great deal. In a focal case in which differentiated and homogeneous goods have identical transport costs, the home-market effect disappears.

In a recently posted paper (pdf), Svetlana Demidova and Andrés Rodriguez-Clare remind us that a curious result lurking in the heterogeneous firms literature – that unilateral trade liberalization decreases a country’s welfare – hinges on exactly that assumption.

It is interesting to compare this result to that in Demidova (2008) for the setting with CES preferences and Melitz and Ottaviano (2008) for the setting with linear demand, where lowering trade barriers for foreign firms reduces welfare at Home. The reason for this result is that such liberalization in country 1 makes country 2 a better export base, which results in the additional entry of firms there. This entry intensifies competition, which results in less entry and lower welfare in country 1. Our model shows that this result no longer holds when there is no outside good pinning down the wage in both countries.

Chaney (AER, 2008) also assumes a freely traded homogeneous good, so I presume that the same conclusion applies in his environment.

The Demidova & Rodriguez-Clare paper introduces a small open economy version of Melitz (2003), which lets them analyze asymmetric trade policies with endogenous wages very nicely in a (relatively) simple setting. Check it out.

“Ricardo revisited”: Back to 2004

In a piece titled “Ricardo Revisited: Sino-American Trade and Economic Conflict,” Ralph E. Gomory and William J. Baumol write:

In this note we look carefully at the impact on a developed nation of the economic development of its trading partner; a trading partner that is developing from a rather undeveloped state. If you want to keep the China-U.S. relationship and the impact on the United States of China’s development in mind as a possible example, you will not go far wrong.

We will discuss what a very standard model, the Ricardo model, shows about this situation. We will see that this very familiar model, properly analyzed, has a number of very unfamiliar consequences. Notably:

  1. The economic development of your trading partner can be harmful to you, the home country.  Although the effect of that development starts out good, it ends badly.
  2. That there is a dominant and dominated relation possible between the two countries that is good for the dominant one and bad for the dominated one.
  3. A country can attain a dominant position only by having an undeveloped trading partner. This can occur naturally if the trading partner is simply there in an underdeveloped state, or the underdevelopment can be brought about by mercantilist actions that destroy that partner’s industries.
  4. There is inherent conflict not only between a nation in a dominant position and its trading partner, but also between that dominant nation and what may loosely be called the interests of the world. In a two-country model of the sort we discuss here this simply is measured as the sum of the benefits obtained by the two countries’ economies.  We assert that from a world point of view, having either nation dominant is bad.
  5. While a country cannot gain a dominant position solely by building up its industries, it can avoid a dominated position by developing its own industries and not allowing them to be destroyed.

We will explain more clearly what we mean by these assertions as we go along… We will also explain enough about the Ricardo model to make that intelligible to those not already familiar with it.

A quick skim of their Appendix A shows that this is literally the standard Ricardian model. They’re just going to discuss comparative statics — what happens to the equilibrium outcome when countries’ productivities change? Unfortunately, a lot seems to obscured by their choice of words.

In the model, countries are symmetric in size and the representative consumers have identical Cobb-Douglas preferences. The “dominant” country is the economy with a larger share of world income — this means that it is more productive and/or makes the good with the larger expenditure share. The words “mercantilist” and “destroy” only appear in the introduction and conclusion, so I can’t say how they’re related to the analysis. Productivity is exogenous in the model and there are no policy instruments, so I don’t see how one avoids destroying industries or can actively frustrate the other economy’s productivity growth.

The word choice is frustrating, because some commentators have interpreted this as an attack on mainstream international economics: “Ralph Gomory and William Baumol, who have posited a much more widely applicable, if equally mathematically watertight, challenge to conventional trade theory.”

Nonsense. This is conventional trade theory. Whip out your copy of Dornbusch, Fischer, and Samuelson (AER, 1977) and turn to page 827:

An alternative form of technical progress that can be studied is the international transfer of the least cost technology. Such transfers reduce the discrepancies in relative unit labor requirements — by lowering them for each z in the relatively less efficient country — and therefore flatten the A(z) schedule in Figure 1. It can be shown that such harmonization of technology must benefit the low-wage country, and that it may reduce real income in the high-wage country whose technology comes to be adopted. In fact, the high-wage country must lose if harmonization is complete so that relative unit labor requirements now become identical across countries and all our consumer’s surplus from international trade vanishes.

According to Arvind Panagariya, this result was first shown by Harry Johnson in the 1950s. It had another widespread discussion in 2004 when Paul Samuelson revived it with a JEP article. (I remember blogging that seven years ago!) I see no challenge to orthodoxy here.

The standard Ricardian model doesn’t have intertemporal dynamics, so Gomory and Baumol aren’t in a great position to do welfare analysis, but let’s discuss it nonetheless. Note that free trade is preferable to autarky in every period. So cutting ourselves off from trade with China isn’t the answer. The options are either to (1) improve US productivity or (2) retard Chinese technical progress. I’m not aware of any free trader opposing the former, and the policy instruments available for the latter are, in the words of Avinash Dixit and Gene Grossman, “to ‘bomb China back into the stone age’ of their older lower productivity.”

How big are the gains from trade?

From an interview of Ed Prescott: “People can quantify what gains there are from it [trade]. If you calibrate the models… most people want to get a big number, but a small number comes out.”

Ed explained that the importance of the difference between openness and free trade lies in explaining the big gains that “trade” generates.  Empirically we know that periods of openness coincide with periods of strong economic growth and periods of protectionism coincide with recession.  Yet the traditional models of trade don’t bear those big-gains results.

There are three theories traditionally used to explain trade, Ed explained:

The first is the Heckscher-Ohlin factor endowments model.  China has a lot of low-skill workers so they produce goods that are labor-intensive, and since the U.S. has a lot of skilled workers, we produce goods that are skill-intensive.  But the gains according to that model turn out to be small.

The second model is David Ricardo’s comparative advantage.  It’s the textbook example: England had a comparative advantage in wool and Portugal had a comparative advantage producing wine, so England produces wool and trades for wine and Portugal produces win and trades for wool.  But that model also yields small gains from trade.

Then there is the increasing returns to scale model from Paul Krugman, who use the Dixit-Stiglitz monopolistic competition model to explore the potential gains from increasing returns.  Yet that, too, turned out small gains.

So clearly there’s got to be some other reason that trade yields big gains for the economies that engage in it. The answer is that “trade” is about much more than the exchange of goods. With openness, there is diffusion of knowledge.

[This isn’t a transcript, but it’s an accurate paraphrasing of the original audio.]

For two examples of such calculations, I’d look at Bernhofen & Brown (AER, 2005) and Broda & Weinstein (QJE, 2006). The former uses the minimal framework of putting an upper bound on the equivalent variation by looking at autarky prices and a counterfactual import vector. The latter impose more structure by using a CES demand system and look at the gains from new imported varieties.

Now, I won’t dispute that technological spillovers and knowledge diffusion are additional channels offering more gains from economic exchange. But how does Prescott know that the gains from trade are bigger than those estimated using the theories above? What is his benchmark? How could one quantify the gains from trade without using some theory?

Arkolakis, Costinot, and Rodriguez-Clare: “New Trade Models, Same Old Gains?”

NBER Working Paper No. 15628:

Micro-level data have had a profound influence on research in international trade over the last ten years. In many regards, this research agenda has been very successful. New stylized facts have been uncovered and new trade models have been developed to explain these facts. In this paper we investigate to which extent answers to new micro-level questions have affected answers to an old and central question in the field: How large are the gains from trade? A crude summary of our results is: “So far, not much.”

What they’re saying is:

Our analysis focuses on models featuring five basic assumptions: Dixit-Stiglitz preferences, one factor of production, linear cost functions, complete specialization, and iceberg trade costs… A common estimator of the gains from trade… only depends on the value of two aggregate statistics: (i) the share of expenditure on domestic goods, which is equal to one minus the import penetration ratio, and (ii) a gravity-based estimator of the elasticity of imports with respect to variable trade costs, which we refer to as the “trade elasticity.”… within that particular, but important class of models, the mapping between trade data and welfare is independent of the micro-level details of the model we use…

A direct corollary of our analysis under perfect competition is that two very well-known gravity models, Anderson (1979) and Eaton and Kortum (2002), have identical welfare implications. In Anderson (1979), like in any other “Armington” model, there are only con- sumption gains from trade, whereas there are both consumption and production gains from trade in Eaton and Kortum (2002). Nevertheless, our results imply that the gains from trade in these two models are the same: as we go from Anderson (1979) to Eaton and Kortum (2002), the appearance of production gains must be exactly compensated by a decline in consumption gains from trade.

Job market papers in international trade

I’ve tried to pull together some of the job market papers featuring trade theory and empirics. I neglect international finance and open economy macro papers here. Feel free to add more in the comments.

Saroj Bhattarai (Princeton) “Optimal Currency Denomination of Trade: Theory and Quantitative Exploration

Lorenzo Caliendo (Chicago) “Estimates of the Trade and Welfare Effects of NAFTA

Camila Campos (Yale) “Incomplete Exchange Rate Pass-Through and Extensive Margin of Adjustment

Arpita Chatterjee (Princeton) “Why Do Similar Countries Choose Different Policies? Endogenous Comparative Advantage, and Welfare Gains

John Dalton (Minnesota) “Explaining the Growth in Manufacturing Trade

Swati Dhingra (Madison) “Trading Away Wide Brands for Cheap Brands

Brian Kovak (Michigan) “Regional Labor Market Effects of Trade Policy: Evidence from Brazilian Liberalization

Zhiyuan Li (UC Davis) “Task Offshoring and Organizational Form: Theory and Evidence from China

Lin Lu (Minnesota) “Trade and Variety: The Effect of Within-Country Income Inequality

Asier Mariscal (Chicago) “Global ownership patterns

Carlos Noton (Berkeley) “Structural Estimation of Price Adjustment Costs in the European Car Market

Soonhee Park (Michigan) “International Fragmentation and Work Effort: Networks, Loyalty and Wages

Ana Maria Santacreu (NYU) “Innovation Diffusion and Trade: Theory and Measurement

Gloria Sheu (Harvard) “Price, Quality, and Variety: Measuring the Gains from Trade in Differentiated Products

Victor Shlychkov (Columbia) “Organizational Forms of Importing Firms in U.S. Manufacturing

Yoichi Sugita (Columbia) “Matching, Quality, and Comparative Advantage: A Unified Theory of Heterogeneous Firm Trade

John Tang (Berkeley) “Pollution Havens and the Trade in Toxic Chemicals: Evidence from U.S. Trade Flows

Marc Teignier-Baque (Chicago) “The Role of Trade in Structural Transformation

Jade Vichyanond (Princeton) “Intellectual Property Protection and Patterns of Trade

Kevin Wiseman (Minnesota) “Location, productivity, and trade

Finicelli, Pagano, and Sbracia: “Trade-revealed TFP”

To the extent that you’re willing to believe in a particular model, you can pull off some interesting exercises, such as “trade-revealed TFP“:

We introduce a novel methodology to measure the relative TFP of the tradeable sector across countries, based on the relationship between trade and TFP in the model of Eaton and Kortum (2002). The logic of our approach is to measure TFP not from its “primitive” (the production function) but from its observed implications. In particular, we estimate TFPs as the productivities that best fit data on trade, production, and wages. Applying this methodology to a sample of 19 OECD countries, we estimate the TFP of each country’s manufacturing sector from 1985 to 2002. Our measures are easy to compute and, with respect to the standard development-accounting approach, are no longer mere residuals. Nor do they yield common “anomalies”, such as the higher TFP of Italy relative to the US.

Via Agent Continuum.

What does Paul Krugman really think about trade theory?

Last week, I attended the Intelligence Squared debate on Buy American/Hire American provisions. It pitted Jagdish Bhagwati, Doug Irwin, and Susan Schwab against Leo Gerard, Rick MacArthur, and Jeff Madrick; the transcript is available online (pdf).

Rick MacArthur, who wrote The Selling of Free Trade and called his debate team “the protectionist side”, opened his speech with an attack on the credibility of international economics. He said Thomas Carlyle labeled economics “the dismal science” because it was not a hard science (not even close), and that free traders cling to David Ricardo “with Marxist fervor.” He then quoted a paragraph from Paul Krugman’s Geography and Trade (1991), which says:

[T]he tendency of international economists to turn a blind eye to the fact that countries both occupy and exist in space — a tendency so deeply entrenched that we rarely even realize we are doing it — has, I would submit, had some serious costs. These lie not so much in lack of realism — all economic analysis is more or less unrealistic — as in the exclusion of important issues and, above all, important sources of evidence.

It’s immediately obvious to anyone familiar with Krugman’s body of work or who notices the link between the phrase “occupy and exist in space” and the word Geography in the title that MacArthur has pulled this quotation out of context. Paul Krugman would likely be one of the last people on earth to say that trade theorists don’t have useful contributions to make. In fact, he says so on the very same page of Geography and Trade:

There is nothing wrong with simplifying assumptions — on the contrary, it is only through strategic simplification that we can hope to make any sense of the buzzing complexity of the real world. The particular simplifying assumptions of conventional trade theory have led to an impressive and very useful intellectual construct. For some purposes it does no harm to ignore the fact that countries are not points and that some pairs of countries are much closer than others — that California is farther from New York than any place in the European Community is from any place else, or that London and Paris are much closer to each other than are New York and Chicago, or for that matter that Canada is essentially closer to the United States than it is to itself.

Yet the tendency of international economists to turn a blind eye to the fact that countries both occupy and exist in space — a tendency so deeply entrenched that we rarely even realize we are doing it — has, I would submit, had some serious costs. These lie not so much in lack of realism — all economic analysis is more or less unrealistic — as in the exclusion of important issues and, above all, important sources of evidence. As I hope I will be able to show, one of the best way to understand how the international economy works is to start by looking at what happens inside nations. If we want to understand difference in national growth rates, a good place to start is by examining differences in regional growth; if we want to understand international specialization, a good place to start is with local specialization. The data will be better and pose fewer problems of compatibility, and the underlying economic forces will be less distorted by government policies.

No intellectually honest person would claim that these paragraphs are ammunition for protectionists against unscientific trade theory. Shame on whomever provided the quotation to MacArthur — he’s been using it out of context for almost a decade now.

David Atkin's "Trade, Tastes and Nutrition in India"

In “Trade, Tastes and Nutrition in India“, David Atkin introduces habits in consumption into a specific factors model of agricultural trade. If a country starts in autarky, then people become habituated to consuming the food produced by their abundant factors. This correlation of tastes and endowments means that when the economy opens to trade, the relative price of that good (for which autarkic consumers developed a habit) will rise. This reduces the consumption of food nutrients in the short-run compared to the habit-free case, as consumers don’t shift over to newly cheap imported foods as quickly as assumed.

Atkin doesn’t focus much on welfare comparisons, which are difficult in such a dynamic, habit-formation context; rather, he’s concerned with nutritional intake. He argues that nutrition matters – policymakers do care, nutrition impacts growth potential, and childhood malnutrition can have persistent long-run effects.

Atkin’s empirical testing ground is India, which has internal agricultural markets that are not very integrated. There are high transport costs, poor infrastructure, and state governments set agricultural policy, including production subsidies and tariffs on agricultural imports from other states.

I examine the predictions of this model of trade with habit formation using household survey data from India, where internal agricultural trade remains highly restricted. I identify tastes with the unexplained regional variation in household demand for agricultural products and find that regional tastes favor food crops that are well-suited to local agro-climatic conditions. I predict that the liberalization of internal agriculture trade in India will generate short-run caloric losses unless income gains from trade are relatively large, and that there would be no such losses if tastes were identical across the country. I also examine the consumption patterns of inter-state migrants, and find that they consume fewer calories for a given level of food spending than otherwise similar consumers. This effect only disappears two generations after migration, as tastes adjust to local prices. These findings, which reflect the higher prices of preferred origin-state goods in the migrant’s destination state, further corroborate the assumptions of my model.